Making Financial Regulation Work: 50 More Years

This is part of a series on The Hearing called "Making Financial Regulation Work." This guest post was written by University of Oregon economics professor Mark Thoma.

Banking regulation imposed in response to the Great Depression and the recurrent panics of the 1800s and early 1900s gave us 50 years of stability in the financial system without impeding economic growth. That’s quite a record to overcome for those who say regulation does not work.

But the stability began to break down with the savings and loan problems in the 1980s, and the growing instability since that time is evident in the severe meltdown we are experiencing today.

What happened? Deregulation beginning with the Reagan administration combined with financial innovation and digital technology led to the emergence of what is known as the shadow banking system. These are financial institutions that, for all intents and purposes, function just like banks but are not subject to the same rules and regulations and, in some cases, are hardly regulated at all.

The development of the shadow banking system is important because the troubles we are seeing today are not the result of problems in the traditional, regulated sector of the financial industry. The problems began in the unregulated shadow banking system.

We need to bring the shadow banking system – essentially any institution that takes deposits and makes loans either directly or indirectly – under the same regulatory umbrella as the traditional banking system.

What type of regulation should we impose to give us the best chance of achieving another 50 years or more of relative calm?

Initially my concerns were with the economic issues, and the focus was on designing a regulatory system that would overcome the market failures that led to excess risk-taking and to institutions that were too big and too interconnected to fail.

But large financial firms exert more than their share of political power, and this adds another dimension to the problem. Banks that are too big and too interconnected to fail pose an economic risk to the overall economy. However, firms can also be “too big for politicians to ignore.” When this happens, they can exert undue influence on legislation or capture the regulatory process in ways that allow them to escape enforcement of rules already in place. So regulation is needed to limit political power as well as economic power.

But that is not enough. The environment the regulatory process operates in must also be changed if we are going to bring about a more stable, more reliable financial system.

Today's problems could have been eased or perhaps even avoided entirely if regulators would have simply enforced regulations already in place, or called for new ones when existing tools were inadequate. But instead, regulations were not enforced to the extent they could have been, and there was little internal opposition when they were lifted.

The attitudes within regulatory agencies were driven by the widely held belief that the discipline of the marketplace would not allow the accumulation of excessive risk. Regulators did not believe that the type of meltdown we have just experienced could occur. Problems could develop in individual markets, and those could be troublesome, but the system-wide, falling-domino-type collapse we’ve just observed just couldn’t happen -- not in modern financial markets with all their digital technology, fancy mathematics, and complicated risk-dispersing products. Or so it was believed.

If you don’t believe something can occur, you won’t be sensitive to signs that it might be about to happen. Regulators missed the signs of the crash because they didn’t think a crash of this breadth and magnitude was possible. Besides, more benign explanations could be made to fit the facts.

We now know that a system-wide financial breakdown was in the realm of possibility, and that should change how regulators view market developments in the future. They won’t soon forget that markets can and do collapse when left unattended, and they will interpret developments in financial markets with that in mind.

So what should we do? In very broad terms, we need:

Regulations that limit both economic and political power and discourage the buildup of excessive risk.

Regulators willing to assertively enforce existing regulation, think outside the ideological box and take an active role in identifying areas where regulation is inadequate.

Regulators with the means and power to stand up to the biggest and most powerful financial institutions. Making financial institutions less powerful by breaking them up into smaller entities is one means to this end.

A culture within regulatory agencies and their supporting institutions that reinforces and encourages the regulatory process.

It won’t be easy to bring about the needed regulatory change, not with still-too-powerful financial companies lobbying against it, but it’s essential that we do.

-- Mark Thoma is an economist at the University of Oregon and blogs daily at Economist's View.

We have developed a tendency in the US, perhaps since some time, to think that bigger was better. I suggest that the SubPrime Mess is a testimony to the danger of that belief. The frenzy of the past five years that made many rich, came to an orgasmic end last year, leaving a great many more poorer.

A country cannot continue forever to assure that the rich get richer and the poor can go to hell. It does no good whatsoever to impoverish one class yet allow another to flourish -- and expect both to live in harmony. Nowhere in our collective memory of civilization has that been known to happen for very long. Even Rome fell from the rot within.

We must come to grips with our penchant for accumulated riches. It is not a God-given right, nowhere is it written in either the Declaration of Independence or the Constitution. Our forefathers were only concerned with the "pursuit of happiness" -- they never mentioned that such could be obtained only by wealth.

And had they believed it, I am sure they would have made it known very clearly.

Greed can be cured effectively by one measure called confiscatory marginal taxation, which will remove the incentive for cupidity ... and make our nation more economically fair than it is today.

Lord knows we need the distribution of the wealth, so easily and regularly generated by our great nation, to be more equitable. But for as long as the immorality of a "what's in it for me" logic prevails in the American mentality and our personal behaviour, then the United States cannot realize its ambition to be a Great Democracy.

What is democracy without economic fairness? An exercise in futility with the haves distancing themselves ever more from the have-nots. Is that our raison d’être? We can do better, I submit.